Question

Problem 15-03
Premium for Financial Risk

Ethier Enterprise has an unlevered beta of 1.1. Ethier is financed with 40% debt and has a levered beta of 1.2. If the risk free rate is 6% and the market risk premium is 6%, how much is the additional premium that Ethier's shareholders require to be compensated for financial risk? Round your answer to two decimal places.

Answer 1

ANSWER

STEP 1 CALCULATION OF REQUIRED RETURN IF NO DEBT IS THERE IN COMPANY

Return Unlevered = Risk free rate + (Unlevered Beta * Market Risk Premium)

= 6 + ( 1.1 * 6)

= 6 + 6.6

= 12.6 %

STEP 2 CALCULATION OF REQUIRED RETURN IF THERE IS DEBT IN COMPANY

Return Levered = Risk free rate + (Levered Beta * Market Risk Premium)

= 6 + ( 1.2 * 6)

= 6 + 7.2

= 13.2 %

STEP 3 CALCULATION OF ADDITIONAL PREMIUM DUE TO DEBT

Additional Premium = Return Levered (-) Return Unlevered

= 13.2 (-) 12.6

= 0.60 %